Take a good look at that chart, from BNP Paribas, for it is the stuff that quant models are made of.
The way this particular model, said by BNP to be a “main work horse” of quant traders, works is this:
Funds trading the Euro-US dollar (EURUSD) typically use a pair trading technique pinched from equities trading models. The currencies model buys EURUSD on a statistical dip below the level of EURUSD implied by the 2-year swap spread. In other words, it assumes a mean reversion between the swap spread and the currency pair.
The weakness of quantitative models (in general) aside, this is usually fine except for a couple things. For a start it’s been forcing the EURUSD to trade within a very specific range — exactly what the eurozone doesn’t need right now. Plus, the swap spread hasn’t decreased by very much since Germany continues to do reasonably well — or at least better than Greece and its porcine brethren.
In short, the quant model is at once increasing the cracks in the eurozone, and cracking.
BNP Paribas’ currency team puts it well in their special note on sovereign woes:
EURUSD is currently traded by four main classes of investors:1. Importers/exporters who have had a non-negligible impact in keeping EURUSD from moving lower 2. Macro hedge funds which had expressed their bearish credit view on EMU via EURUSD bearish positions 3. Systematic funds who trade EURUSD in deviation to the 2 year EURUSD swap spread 4. Central Bank and Sovereign Wealth Funds which have generally under-invested in EUR and likely USD and behave as a mix of macro and systematic funds. The net impact of this activity has been to temporarily block the downward path of EURUSD, a tragedy for EMU as it has accelerated the next wave of the sovereign crisis and triggered the Greece rescue package.
And here’s where things get rather scary:
We have already seen such problem earlier in the CDO market where correlations between two assets were calibrated to the market. The problem is that under stress the correlation between credit grades, or here between EURUSD and the swap spread, breaks down rather brutally as a credit crisis develops. Incidentally, this is one of the main reasons for the fall of Lehman.
It is happening again. Large parts of EMU such as Greece are now unable to operate at current levels of the EURUSD as they are simply completely uncompetitive. When EURUSD reached 1.50 in November 2009, Greece was actually operating at 1.80 when adjusting for its much higher labour costs relative to Germany. Indeed, the problem is worsening as the German economy and likely others will deflate much faster than Greece. Germany has already agreed to a zero wage round.
Hence, the tragedy of the quants is to have helped to bring about the second wave of the current crisis and to continue to buy on dips looking also for a squeeze in bearish EURUSD positions. The more we wait, the larger the potential crisis in Europe and the consequent adjustment lower in EURUSD.
Oh dear.
Related links:
The CDS market doesn’t believe in Greek containment – FT Alphaville
EURUSD – the ’slow-bleed restructuring scenario’ – FT Alphaville
‘It is relatively clear that (in economic terms) the Euro does not work’ – FT Alphaville
The end of the euro – FT Alphaville